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One year ago this week, Microsoft completed its $7 billion acquisition of Nokia’s smartphone business. The deal transformed Microsoft into a mobile phone maker, with its own line of first-party mobile devices to go along with its longtime presence in mobile operating systems, apps and online services.

lumiaA year later, the good news for Microsoft is that its smartphone business is growing. The company sold 8.5 million Lumia smartphones in the March quarter, an increase of 18 percent from the same quarter a year ago, according to data released as part of Microsoft’s latest earnings report.

By comparison, however, Apple is expected to report as many as 60 million iPhones sold during the same quarter, when the company releases its earnings this afternoon.

And Microsoft is learning first-hand that hardware is a brutal business. Profit margins on smartphones are already thin, especially from the perspective of a longtime software company, and the source of Microsoft’s growth — lower-priced devices — makes things even tougher.

Microsoft’s Lumia unit growth is coming largely from the “value smartphone” segment — the wave of lower-priced Lumia smartphones announced and released by the company over the past year. As a result, Microsoft’s gross margin on phone hardware was a loss of $4 million for the recent quarter, on sales of $1.4 billion, as reported in the company’s quarterly regulatory filing.

Microsoft CEO Satya Nadella acknowledged the situation on the company’s earnings conference call: “We continue to demonstrate momentum in the Value Smartphone segment of the phone market, driving 18% growth in Lumia volume this quarter,” he said. “However, we need to take further action to reduce our costs across devices as we execute on our Windows 10 first-party hardware plans.”

Here’s what the trends look like, as reported in Microsoft’s investor slides for the quarter. (Click for larger image)

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Windows Phone has pockets of strength overseas, but its overall share of the U.S. smartphone market, including Windows Phones made by other companies, remains in the low single-digits.

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Microsoft doesn’t appear to be ready to give up on Windows Phone anytime soon. The company reiterated in its latest quarterly filing, “The success of the Windows Phone platform is an important element of our goal to enhance personal productivity in a mobile-first and cloud-first world.”

But in the meantime, these trends help to explain why the company is hedging its bets by releasing its apps and services so aggressively for Android, iPhone and, yes, even the Apple Watch.

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